Bangladesh Bank Training Academy Journal

Abstract

The dynamic causal relationship among budget deficit, money growth and inflation remains a contentious and lively issue in the literature. Even though the literature on this issue is voluminous, however for Bangladesh it is quite a few. The studies on Bangladesh suffer from methodological deficiency as they did not take into consideration the time series properties of the variables and also suffer from omitted variable bias. This paper overcomes the early studies in terms of data used and techniques applied. This paper also overcomes the methodological deficiency by considering Keynesian and monetarist’s contention in analyzing inflation of Bangladesh. The main contribution of the paper is to address the issue of the short run dynamics of the considered variables within a long run relationship. The empirical results show that there is a unidirectional causality runs on budget deficit to money supply, which is supported both by Granger causality as well as by error correction model. Theimplication of the result is that in Bangladesh budget deficit is monetized by printing money. The study also found that there is a unidirectional causality from budget deficit to money supply and money supply to inflation. The implication of the result is that expansionary monetary policy to combat budget deficit has important effect on the inflationary pressure in Bangladesh, which is in line with the earlier studies in Bangladesh except Taslim (1982). The overall implication of the result is that inflation in Bangladesh is a fiscal driven monetary phenomenon. Therefore to maintain inflation at a tolerable rate budget deficit should be financed by other means than printing money.